Goals led Dell to cook the books

Though Dell has finished an internal investigation into its accounting practices, there are still plenty of questions about the company, which not long ago could do no wrong in the minds of investors and customers.

What we know now is that Dell's finance department was apparently willing to fudge numbers to ensure it would hit or surpass its quarterly earnings forecasts. The unit seems to have done that with the knowledge of, or sometimes at the request of, senior executives. And the guilty parties did it because Dell's accounting department didn't strictly follow generally accepted accounting principles, or GAAP, Chief Financial Officer Donald Carty said in a conference call Thursday afternoon. Carty became CFO after Jim Schneider stepped down in January.

The department used "inappropriate accounting decisions and entries that appear to have been largely motivated to achieve desired accounting results," Carty said during the call with investors, apparently reading from a document filed with the Securities and Exchange Commission explaining the results of the company's investigation.

The SEC's separate investigation is still under way.

Dell felt so pressured to meet Wall Street expectations that its finance department bent accounting rules to make up for shortfalls in certain quarters and underreported earnings results in others, each time ensuring that Dell seemed to hit earnings targets that financial analysts were expecting. Carty didn't go into detail, but it appears much of the accounting manipulation involved the timing of expenses and payments recognized on Dell's balance sheets.

Donald Carty

So who knew about the financial shenanigans, and when? Carty said executives knew and even encouraged it, but he won't say exactly who those executives were, and is so far refusing to single anyone out for responsibility. "I'm not going to talk about any individual by name," Carty said. "We've taken what we believe to be appropriate actions with respect to personnel involved in this, up to and including terminations."

More importantly, how did this happen at a company widely considered to be conservative and, above all, trustworthy? Dell's explanation is that not only did it not maintain a culture that emphasized strict adherence to GAAP rules, it didn't have enough employees with the proper accounting training or experience to know better.

In addition, Dell says inadequate resources in its accounting department are partly to blame, and--in a remarkable acknowledgment for a company that pioneered selling computers on the Internet--that much of its accounting is done manually, with very few electronic trails.

Carty acknowledged that Dell is "underinvested in IT resource in the financial area." He also told investors "financial systems can't be blamed for irregularities, but they can occasionally be blamed for errors."

Dell's accounting department used "inappropriate accounting decisions and entries that appear to have been largely motivated to achieve desired accounting results."

--Donald Carty, Dell CFO

It's not uncommon, of course, for companies to be motivated by short-term results. It's just surprising that Dell has become such an egregious example of that short-term thinking.

"I think every company that's public feels the pressure of being a public company and (hitting) quarterly numbers. I think that's why you see companies issuing quarterly guidance," said Brent Bracelin, a financial analyst with Pacific Crest Securities. "It certainly isn't a comforting feeling that they were manipulating numbers. It happened in the past. (The) most important thing is they addressed it and quantified it."

Overall, the financial impact to Dell's bottom line is limited. Between fiscal years 2003 and 2006, Dell's net income was more than $12 billion. The audit committee now says that the actual net income Dell earned during that period is $50 million to $150 million less. Earnings per share for that time frame will likely be 2 cents to 7 cents per share lower.

But how, exactly, does something like this happen? A look at the Dell quarters in question (notably, a period when the company was being praised for strong profits while rival Hewlett-Packard was struggling to meet Wall Street expectations) may provide some answers.

In the first quarter of fiscal year 2003, Dell announced profits of $457 million, or 17 cents per share, on revenue of $8.1 billion for the quarter. Analysts had been expecting a profit of 16 cents per share and revenue of $7.86 billion, according to First Call.

According to the corrected information Dell released Thursday, the net income for that quarter should have been 10 percent lower, around $410 million. Against 2.67 billion outstanding shares that quarter, that would have been 15 cents a share, missing expectations.

In Dell's second quarter of fiscal 2004, the PC maker reported net income of $621 million, or 24 cents a share. Analysts had been expecting 24 cents a share. With the restatement, Dell should have earned $561 million, or 21 cents a share.

The fourth quarter of Dell's fiscal 2005 was an anomaly, as the company took a one-time charge of $280 million for repatriating foreign earnings after the passage of the American Jobs Creation Act. GAAP net income for that quarter was $667 million, or 26 cents a share. Without the charge, it was $947 million, or 37 cents a share. Analysts were expecting, without the charge, 36 cents a share.

After the restatement, Dell actually earned $620 million in GAAP net income, or $900 million without the charge, which would have been 35 cents a share.

The main problem was in the way Dell was keeping track of its reserve and accrued liability accounts, which is money set aside, for example, when the company sells a warranty on one of its computers. It's up to Dell to estimate how much will be necessary to set aside should someone call in a repair on their computer. The difference between, say, $50 and $100 isn't much for one computer, but when multiplied by 1 million warranties, it adds up quickly.

The problem with reserve accounts is that they're quite easily manipulated because there's no absolute rule on how much money to set aside, said Tracy Coenen, founder of forensic accountant firm Sequence.

"You can play games with it. It's one of those gray areas in accounting," she said.

Fixing the problem
To make sure this doesn't happen again, Dell says it is reorganizing its finance department. Accounting and financial reporting duties will be kept separate from the people responsible for planning and forecasting future quarters. The position of chief accounting officer has also been "strengthened" and will be responsible for all accounting and financial reporting responsibilities for the entire company.

But even news of numbers being manipulated may not hurt Dell all that much in the financial community. Some investors just seemed relieved that the company could move on from the investigation, which prevented Dell from filing any official earnings reports or giving any guidance about the state of its business for the last year.

"The cumulative impact is not that meaningful, but I think that the main takeaway is that they're now ready to put this behind them," said Bracelin of Pacific Crest. "They're now in a position to fix some of the deficiencies they found, and from an analyst perspective, or an investor's perspective, people don't invest in companies based on what they did. People invest based on what they will do."

Dell executives continue to cooperate with the government's probe, Carty said. But the biggest concern for Dell, which is dealing with shrinking market share, exploding laptop batteries and an increasing perception that its products are decidedly bland (despite a new effort to ), is how this will play out with customers.

"You don't want any questions," said Samir Bhavnani, an analyst with Current Analysis West. "They've been doing a bunch of things good to get back on their feet a bit and this is a pretty big speed bump. Hopefully they're able to get over it."